Quad/Graphics, Inc. (QUAD) Q4 2012 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Quad/Graphics Fourth Quarter 2012 Conference Call. [Operator Instructions] I would now like to turn the conference call over to Kelly Vanderboom, Vice President and Treasurer for Quad/Graphics. Kelly, please go ahead.

Thank you, operator, and good morning, everyone. With me today are Joel Quadracci, our Chairman, President and Chief Executive Officer; John Fowler, our Executive Vice President and Chief Financial Officer; and Dave Honan, Vice President, Corporate Controller and Chief Accounting Officer. Joel will lead off today with a high-level review of the quarter and provide an update on our key strategic goals. John will follow with a more detailed review of our financial results, which will then be followed by Q&A. I would like to remind everyone that this call is being webcast, and forward-looking statements are subject to Safe Harbor provisions as outlined in our quarterly news release and in today's slide presentation. The slide presentation can be accessed through a link on the Investor Relations section of the Quad/Graphics website at www.qg.com. There are also detailed instructions on how to access the slide presentation in our fourth quarter earnings press release issued last evening. A replay of the call will also be posted on the Investor Relations section of the Quad website after the live call concludes. I will now turn the call over to Joel.

Thanks, Kelly. Good morning, everyone, and thank you for joining our call today. I am pleased to report that our fourth quarter and full year 2012 performance was in line with our expectations, and I'm especially pleased with our continued track record of solid and consistent free cash flow generation. We ended the year with an annual recurring free cash flow of $375 million, which surpassed our upwardly revised guidance of $340 million. Our ability to maximize recurring free cash flow positioned us well in 2012 to make progress on our priorities to maintain balance sheet strength and flexibility, maintain strong credit metrics, invest in value-driven industry consolidation opportunities and return capital to shareholders. During the fourth quarter, we were able to return cash to our shareholders through a special $2 year end dividend and also increased the 2013 quarterly cash dividend by 20% to $0.30 per share. In addition, we paid down $120 million of debt and our leverage ratio, even after our special year end dividend, was 2.39x and remains within our targeted range of 2.0x to 2.5x. On January 16, 2013, we completed our acquisition of Vertis and welcomed approximately 3,900 new employees to our family. The combination of Quad/Graphics and Vertis is a natural and strategic fit, and key benefits from the acquisition include: an enhanced position in the production of retail inserts, direct marketing and in-store marketing solutions, an enhanced range of products and services, extended expertise in more vertical markets, an extended geographic footprint that increases our manufacturing flexibility and distribution efficiencies. In 2012, Vertis generated approximately $1.1 billion in annual revenue, which has been included on a pro forma basis in our 2012 revenue summary on Slide 4. Retail inserts is now our largest product line at 25% of our total revenue on a pro forma basis. With an enhanced coast-to-coast national platform of 32 strategically located facilities in the U.S., we have expanded our ability to version and produce distinctive retail insert formats closer to their final destination point. In addition, through our Media Solutions offering, we can help our clients -- our retail clients strategically plan and place media based on store location and market analysis, achieve cost savings through on-site facilities management services, develop workflow solutions to streamline content management and page assembly workflows and connect print content to the web, tablet and mobile channels. This, coupled with our expanded range of large-format and point-of-purchase products from our in-store marketing division called Tempt helps us provide marketers with a one-stop integrated solution approach to drive store traffic and ensure brand consistency. Also with the acquisition of Vertis, our direct marketing product line has grown to 9% of our total revenue on a pro forma basis. We have greater flexibility to create relevant and effective direct mail formats for our clients. Additionally, we have expanded our vertical market expertise in financial, insurance, telecom, health care, nonprofit and automotive. Our data-driven direct marketing solutions are tailored to our clients' unique marketing needs and designed to improve ROI. We incorporate one of the industry's most advanced in-line inkjet personalization techniques with innovative digital printing, variable data printing and conventional and enhanced letter shop capabilities. This, along with our data reporting solutions and greater scale will help drive further efficiencies, such as improved postal delivery optimization through commingling. Like co-mail for magazines and catalogs, commingling for direct mail provides our clients with significant postage discounts while also reducing handling and improving delivery time. Slide 5 is the summary of our 4 strategic goals, which we believe will allow us to be successful despite ongoing industry challenges. Our strategy to transform the industry is tailored by product line and geography but driven by a common purpose to create value in 3 distinct ways: First, we maximize the revenue of our clients derived from their marketing spend through media channel integration to create measurable client value. Channel integration is something that I spend a lot of time in the marketplace talking about with our clients. What I hear on a consistent basis from them is a growing concern around an ever changing media landscape and their ability to connect all channels together and impact consumer behavior. As a printer and media channel integrator, we have the tools and capabilities to help our clients navigate today's multichannel world, by capitalizing on prints' ability to complement and connect with other media channels. We do this by leveraging the power of print with data analytics and leading-edge technology to help our clients retain their existing customers, acquire new ones, drive higher response rates and promote a consistent brand across channels. Another key element of our strategy to transform the industry is our ability to maximize our clients' overall total cost of production and distribution. Distribution and mailing costs typically represent the largest percentage of our clients' total cost of production. To create client value, we continually strive to increase our own productivity while reducing our clients' mailing and distribution costs, through utilization of our efficient and fully integrated national distribution network. For example, during 2012, we co-mailed approximately 5 billion magazines, catalogs and direct mail pieces, which represented a 5% increase over 2011. A key differentiator in our offering is our ability to combine this volume with our unique software to merge mail streams. Through our co-mail offering, we are able to provide our customers with significant postage savings, and we believe this gives us a long-term sustainable advantage versus our competition. Our ability to select and successfully execute value-driven industry consolidation opportunity represents the final component of our strategy to transform the industry. Given the challenges facing the industry, we believe our modern and efficient manufacturing platform and financial strength provide us with a competitive advantage in this area. Through consolidating acquisitions, we will be able to expand into new markets or add complementary capabilities and create significant efficiencies in the overall production and distribution process. We have a disciplined, value-driven approach when selecting an opportunity to ensure the following criteria are met: First, we conduct a thorough review process to ensure the potential acquisition will have a good strategic fit. We also follow a disciplined approach to make certain the economics make sense and we make sure that the integration plan is executable in a timely manner and without risk of significant client disruption. Finally, we assure that post-acquisition, we retain the financial strength and flexibility we had prior to the acquisition. A perfect example of this strategy is our recent acquisition of Vertis. The Vertis acquisition met all 4 of our criteria. And I'm pleased to report that our integration process is progressing as planned, and John will provide a bit more color in our financial overview. Our second strategic goal focuses on maximizing operational and technological excellence. Due to a disciplined return on capital approach to investments, we believe we have one of the most automated, efficient and modern manufacturing platforms in the industry. In addition, our commitment to lean enterprise and a culture of continuous process improvement continues to be a high priority throughout our company and supports our goal of being the low-cost producer in the industry. As a company, we're making progress toward this goal by remaining focused on a few key areas: First, we make a concerted effort to treat all costs as variable, including costs that are traditionally thought of as fixed. We focus on sustainable cost reductions in both nonlabor and indirect labor spending. We also continue to take a disciplined approach to improving capacity utilization and productivity across our platforms and we remain focused in our pursuit to take out direct cost through a variety of means, including the maximization of labor mix and the expansion of continuous improvement programs to produce -- reduce waste, eliminate redundancies and shorten cycle time. Our third strategic goal focuses on our ability to empower, engage and develop our employees to think and act like owners and create solutions that advance the company's strategic goals. To help employees, we provide training and education programs throughout their careers. Much of this training is exclusively developed for our employees by our Quad/Education division along with our continuous improvement and safety groups. One example is our Leading Within Quad management training program. This multiyear program helps leaders develop a deeper understanding of our company, the industry, their own leadership competencies and Quad's unique company values. Leading Within Quad is also providing a solid framework for acclimating our newest family members from Vertis to our culture. Our final strategic goal is to enhance financial strength. This strategy is centered on our ability to maximize free cash flow and earnings, maintain consistent financial policies to ensure a strong balance sheet and liquidity level and retain the financial flexibility we need to strategically allocate and deploy capital. As we have said, our priorities for capital allocation will be adjusted based on prevailing circumstances and what we believe is best for shareholder value creation at any particular point in time. These priorities currently include: Deleveraging the company's balance sheet through debt and pension reductions, pursuing long-term profitable investment opportunities, returning capital and creating long-term value for our shareholders. As we look forward, we remain confident in the strength of our balance sheet and the cash generating power of our company. With that, I will hand it over to John, who will present a more detailed financial review.

Thanks, Joel, and welcome, everyone. Slide 6 is a snapshot of our fourth quarter 2012 financial results as compared to our fourth quarter in 2011. Net sales were $1.1 billion as compared to $1.2 billion. Cost of sales at $872 million was lower as compared to $921 million. SG&A expense of $87 million was lower by $22 million as compared to $109 million. Depreciation and amortization was $86 million as compared to $89 million. Interest expense was $20 million as compared to $24 million, primarily due to our focus on debt reduction. Our adjusted EBITDA was $174 million as compared to $187 million and our adjusted EBITDA margin of 15.3% was essentially even with last year's margin of 15.4%. We have once again included an adjusted EBITDA bridge in our slide deck to better explain the impacts to adjusted EBITDA in the quarter. There are 3 major positive impacts for the quarter: First, a reduction in selling, general and administrative expense of $17 million. This reduction was due to our focused effort to create sustainable cost reductions over and above the Worldcolor integration synergies. Second, our incremental synergies from the acquisition of Worldcolor were $7 million; and third, a $4 million reduction to our bad debt provision as compared to a higher-than-normal bad debt provision in the fourth quarter of 2011. This positive impacts were offset by volume declines and pricing pressures on print and byproduct revenue that impacted adjusted EBITDA by $36 million during the quarter and $5 million that was attributable to the book business, which reflects both volume and productivity issues. As Joel mentioned, we are proud of our consistent, recurring free cash flow and the work we are doing to maintain a strong and flexible balance sheet. Our recurring free cash flow was $375 million for 2012 as compared to $340 million in 2011. We define recurring free cash flow as cash flow from operating activities, which includes pension contributions, less capital spending and excluding nonrecurring items, such as restructuring costs. We believe this is an important metric for us, and we expect the business to continue to generate a significant amount of recurring free cash flow. The reconciliation of recurring free cash flow for the 12 months ended December 31, 2012, is included in the supplemental information located in our slide presentation. Our strong recurring free cash flow provides us with the ability to pay down our debt and pension liabilities, invest in our business and return capital to our shareholders. During 2012, we paid down debt of $120 million after paying the special year end dividend of $94 million. Since the close of the Worldcolor acquisition, we have paid down a total of $444 million. Our pension -- multiemployer pension plans, or MEPPs, and postretirement liabilities were $547 million as of July 2, 2010, when we acquired Worldcolor. As of December 31, 2012, this liability was $378 million, representing a decrease of $29 million during the year and a reduction of $169 million since the acquisition. As anticipated, this liability increased $44 million as of December 31, 2012, as compared to the September 30 balance, due to a $67 million negative impact of an anticipated lower discount rate, partially offset by asset returns higher than our 6.5% return assumption and company contributions of $4.4 million. Slide 9 provides a summary of our debt metrics. Our interest coverage ratio for the quarter increased to 6.7x versus 5.9x at the end of last year. After the payment of our special dividend, our leverage ratio of 2.39x remains within our targeted range. We continue to believe that operating in the 2.0x to 2.5x leverage range is the appropriate target. However, we acknowledge that at times, we may decide to go above or below that range given economic changes, working capital seasonality, timing of investments and growth opportunities. At the top of Slide 10, you will note that we have $50 million of borrowings under our $850 million revolver as of December 31, 2012. Interest expense decreased 14% to $20 million as a result of our debt pay down. Our floating rate debt today is at an average interest rate of 3.1%. Long-term fixed rate debt, consisting of private placement notes, continues to be at an average interest rate of 7.4% and have an average maturity of 10 years with the weighted average life of 6 years. The blended interest rate on our total debt is 4.9% and the outstanding principal balances are 57% floating and 43% fixed. We have no significant debt maturity until July 2017. During the fourth quarter, we extended the maturity of our term loan A, which had a balance of $444 million at year end and our bank revolver by 1 year to 2017. Given the flexibility under our revolver and our strong recurring free cash flow, we believe we have sufficient liquidity for current business needs, sustaining the increase dividend and supporting future investments. Slide 11 is a snapshot of our full year 2012 financial results as compared to 2011. Net sales were $4.1 billion as compared to $4.3 billion. Cost of sales at $3.2 billion was lower as compared to $3.3 billion. SG&A expense was $347 million as compared to $407 million. Depreciation and amortization was $339 million as compared to $345 million and interest expense was $84 million as compared to $108 million. Our adjusted EBITDA was $566 million versus $618 million and our adjusted EBITDA margin was 13.8% as compared to 14.3%. As it relates to 2013 guidance, we anticipate our revenue, which, as a reminder, will now include Vertis, to be approximately $4.8 billion to $5.0 billion. We expect that our adjusted EBITDA to be $580 million to $610 million and recurring free cash flow to be in excess of $360 million. As it relates to Vertis, we believe that the core Vertis business would have generated approximately $45 million of EBITDA in 2013 as a stand-alone business. Over the course of 2013 and 2014, we anticipate synergies to be an excess of $50 million, primarily from SG&A, platform integration and procurement initiatives. We expect our cost to achieve both from expense and capital investment to be approximately $1 of cost to generate $1 of synergy. It's important for you to understand that we are completely integrating our 2 direct marketing and retail businesses. We feel that it would be arbitrary to differentiate what is original Quad or original Vertis EBITDA and what is synergy versus what is normal ongoing cost reductions required to be successful in the printing industry. Therefore, we intend to report our results for 2013 from a total one company perspective versus reporting individual acquisition components. The remainder of our 2013 guidance includes depreciation and amortization of $340 million to $350 million; interest expense of $85 million to $90 million; capital expenditures of $150 million to $175 million, which includes a $15 million carryover from 2012; and cash taxes of $25 million to $30 million. We expect the cash contributions to our single-employer pension and OPEB plans to be $45 million. Due to the addition of the Vertis business that closed in mid-January, we would expect that our earnings would be more second half weighted in 2013 as compared to 2012. As we move forward in this challenging industry, a component of our strength is having a balance sheet that is strong and flexible so that we can adjust to changing economic conditions, invest in our business, pursue profitable investment opportunities and return cash to our shareholders. As Joel mentioned, we have increased our 2013 quarterly cash dividend by 20% to $0.30 per share, and the next dividend will be payable on March 29, 2013, to shareholders of record as of March 18, 2013. I would now like to turn the call back to the operator, who will facilitate taking your questions. Operator?

[Operator Instructions] Your first question comes from the line of Haran Posner with RBC.

Starting with your guidance. I was wondering if you can give us a sense for just sort of what the economic backdrop is for some of your assumptions.

Well, I think as we kind of look forward here -- you've probably gotten to know us as being a little bit conservative on our outlook of the economy these days because I think that there's obviously a lot of things playing out. We've seen some modest signs of life here. I think if you look at what's been published out there publicly on first quarter ad pages, we've seen some growth; it's somewhere around 5 percentage points. And we've seen stability in our catalog product line. So I think that's all good stuff, but I think we also want to rely on making sure that it's more than just a short-term trend and a longer one. I think what we like to do is remain cautious about the economy. But I will tell you what I'm really bullish about is our ability to manage whether the economy continues to be a slow one or capture the upside if it does in fact recover. Certainly, we're seeing the market take off today. There's all sorts of positive things. But I will say, we also look at like our average employees getting hit with the payroll tax or getting hit with gas cost. And so the average people out there yet are still feeling headwinds. And I want to make sure that hopefully with that bit of good news in the economy with housing and the market start to translate into good news in the consumer. A lot of this stuff is going to be based on the consumer confidence that is out there. And so I'd say that we're, I think, cautious but seeing signs of optimism in what the economy's doing.

And Joel, just to follow up. You said upwards in ad pages, you saw growth. Is that for what period again?

And this is out there. I mean, I think the industry reports on it, and I'm talking from an industry standpoint. A lot of them saw towards the back end of the year about 5% increase in ad pages. I mean, overall, for the year, ad pages were down about, for '12, were down about 8% but kind of started correcting towards the end. I will tell you that in our mix of customers, our rate was about half that because I think that sort of speaks to the quality of the publishers we have in our mix. But in the first quarter, what we've heard from clients and this is publicly out there is they're seeing somewhere around a 5% increase in ad pages for the first quarter. I will say that after April, their visibility drops off very quickly, as the -- I think the advertisers are still waiting to see how trends happen and things happen much later in the day in terms of decisions than they've had before.

Okay, that's great color. Maybe shifting to the Vertis integration. Just to clarify, did you say $50 million, $5-0 million in synergies in 2013 and '14?

Yes. We said -- well I said, in excess -- I mean, we're still kind of early on into it. But that would be our estimate, would be that.

And John, how should we think about modeling that? Is it fair to kind of think about it as kind of a linear ramp? Or is it going to be more early weighted?

I think lineal is a reasonable way. I mean, some things you're going to get more quickly in the procurement and SG&A, some of the plant integration will come more slowly as we integrate the plants and move work around.

Okay. And then when I go look back at your integration of Worldcolor, at least initially there was a period where you sort of experienced, what you described at the time, as frictional costs, as sort of you migrated the production. And I was just wondering if that is something that you would expect this time around, and if so, to what degree?

When you move work, you're always going to have these "frictional costs". I think we, frankly, probably created more confusion around that than we created value. So when we shared the in excess of $50 million and how it's going to flow out, that's taken into consideration.

And I think in the Worldcolor case, I mean, it was such a significant acquisition with so many pieces of business moving from one place to the other, with more complication in those product lines that are actually in the retail product lines. If you remember, retail is really a product of press. So most of the time, it doesn't encompass all of the finishing operations where a lot of the complexity are. So we don't anticipate experiencing as much of a frictional sort of experience as we did. But that being said, every integration has cost to it but we're not going to be talking much about those.

Your next question comes from the line of Jamie Clement with Sidoti. James Clement - Sidoti & Company, LLC: Joel, I know you all put out a press release in response to your trip to Washington about postal reform. If in fact, USPS does do away with Saturday delivery, does that -- is there a group of your customers for whom that does impact in a meaningful way? And if you just care to kind of go into your postal thoughts just a little bit more for us and see how -- where Quad fits into the mix there?

So you want me to go postal. Well, let me -- first of all, the 5-day delivery thing is -- this is not a new... James Clement - Sidoti & Company, LLC: And if I -- John, is that the 10th time you've said that over the last 2 weeks, just out of curiosity?

No, no, no. So the 5-day delivery thing is not a new concept out there. This has been in the works and talked about for quite a long time. Some of our customers get more affected from a production standpoint, like weekly magazines because they all want to be in the same spot. So if the spot has to move, they're all competing for that. So it's like the timing contract we talked about, our production platform, all that was anticipated in terms of ultimately going to 5-day. I think that the Postmaster General says he's going to do it earlier. I tend to think that, that was a little bit of positioning and it may still happen earlier. But it's to get Congress's attention. You remember, last year there was a bill to fix all these problems, or most of them, that failed in the House. And what was different this time on the Hill is I went up to testify in front of the Senate Committee on Homeland Security where the post office goes through, a couple of members of the House actually came up to that hearing to testify first, and they were all openly supporting getting this fixed, which is not very normal. So that's a good sign. I think everyone kind of understands the issues here. And there's a lot of people who think that this is on the backs of the taxpayers, the reality is that the post office is funded by postage and the goal is for it to be self-sustaining. The problem is, it has twice the infrastructure it needs for the volume it has, and they've been aggressively and successfully pulling significant costs out, but Congress wants them to run like a business that's still shackled to them. And so part of that, what we want to see in the bill is for them to make sure that they can go faster and they can do the right things because everyone has a post office in their backyard. And when anybody tries to merge 2 post offices together, every congressman hears from their consumers that they don't want to drive that far. So what we know is the consumer doesn't want the post office to go down and won't let it go down. And so the other big issue there is they have to prefund their retirement health care to the tune of $5 billion on a 10-year amortization. The goal here is to change it to 40 years, which is very realistic and they've overpaid into the pension by somewhere around $5 billion to $20 billion or $12 billion, depending on who you talk to. So all of the things that they're asking for, none of this comes from the taxpayers. So the big question here is "Okay, do you want the post office to be self-sustaining on postage or not?" And if not, then you have to get comfortable subsidizing the post office on the taxpayers' back because that's what they'll have to do. And I think everyone understands they'd rather have it fixed, and I think we'll see some good momentum. That being said, Washington is, as you know, an interesting place these days, and hopefully they can work together. So those are my thoughts on it. And I don't see a significant impact to us on the 5-day delivery nor our clients. However, I did say that when we think about how print continues to play the multichannel world, I think marketing needs to be much more immediate these days. And typically the last thing you should do is pull away service. And to some degree, it does change a little bit of the immediacy factor. But hopefully, the bill, it will be just like it did last time, which allowed them to go to 5 days, 2 years from now, as a last resort for fixing. So it's a long-winded answer but it's top on my mind because remember, postage is over 50% of a client spend, which is why we spend so much time talking about our ability to pull cost out for them on the postage spend. James Clement - Sidoti & Company, LLC: Quickly, what I was curious about was, are there titles out there? And for whatever reason, I always tend to think of catalog but maybe I'm wrong in being that limited, where it's like, you know what, they shoot for Saturday delivery and their data analytics suggest that if they don't get Saturday delivery then they have a problem. And I guess the sort of -- the context of my question is that when I ask people in the industry about 5-day delivery, they generally say it's no big deal. Yet at the same time, they fight very strongly against it. So I guess, if I -- I hope that's a fair follow-up question.

Yes. Again, I don't think people want to see less service. I mean, as a customer, to my vendors, the last thing I want to see is less service. But if things have to be done, the industry, I think, has been, for the most part, generally supportive with the idea of pulling cost out. The volumes on Saturdays tend to be lower. And even if they pull Saturday away, we're really pushing for them to keep the production going on those facilities because we still have to deliver mail. And so I -- it's going to affect people different ways. But generally speaking, they want to get there before the weekend and retailers want to get the stuff to you before the weekend when you're going to go spend, and Saturday is the day when hopefully you've already gotten the message.

Your next question comes from the line of Dan Leben with Robert W. Baird. Patrick C. Wang - Robert W. Baird & Co. Incorporated, Research Division: This is actually Patrick Wang for Dan Leben this morning. First off, appreciate the color on the 2013 guidance on EBITDA, breaking out the $45 million as attributable to a stand-alone Vertis. Do you have a similar guidance for -- in terms of revenue, what would have -- what would Vertis have been as a stand-alone in 2013?

We would expect that Vertis, on a stand-alone basis would have been approximately $1 billion. Patrick C. Wang - Robert W. Baird & Co. Incorporated, Research Division: Okay. So very -- pretty similar to 2012?

They're at $1.1 billion. I mean, they did have downward momentum that was caused by the financial challenges and exasperated when they went into the bankruptcy to facilitate the sale process, so a little steeper. Patrick C. Wang - Robert W. Baird & Co. Incorporated, Research Division: And then just really quick on the 2013 recurring free cash flow guidance, I know that during the acquisition of Vertis, you guys mentioned that it was $97 million of the portion of current assets in excess of working capital. Is that included in that $360 million guidance figure?

Yes, we would expect that a vast majority of that would come back into 2013. Probably the order of magnitude of $85 million to $90 million of it would be restored during '13. Patrick C. Wang - Robert W. Baird & Co. Incorporated, Research Division: Okay, wonderful. And then from an integration challenges standpoint, you guys mentioned earlier on the call that with the product mix, you're not facing the same level of complexities as the Worldcolor acquisition. But is there any other areas where you anticipate challenges, whether it's with customer overlap and retention?

No. I think that -- I started seeing the customers right after we closed the deal, literally that day. And you're always going to have some risk of clients moving or not but I think we maintained a pretty good track record of keeping them on board. And I think that they have a very loyal client base because Vertis, the employees of Vertis, I have to tell you, my hat is off to them. Because as I've made my way around both to the clients and the customers, they've really performed well for them. And so I think it's just a matter of their customers getting to know us. And by the way, there were a lot of areas where there wasn't an overlap. Again, they brought some segments to us that we didn't really play well in or played much in, which would be things like grocery, the things I mentioned before. But I think the financial stability we bring is going to be key to these clients. And I know that as much as they like Vertis, they were getting nervous, and so I think we've been able to alleviate a lot of that. Okay. Well, I want to thank everyone for joining us. But first of all, I want to thank all the Vertis employees. I have been just absolutely amazed by what I've seen and what I've heard and really thank everybody involved in this process to pull these 2 great companies together. And so with that, we'll see you all next quarter. Take care.

This concludes today's conference call. You may now disconnect.